In September 2013, the economist Raghuram Rajan became the head of the Reserve Bank of India. Since then, India has had to cope with slow growth, a widening current account deficit, and a depreciating rupee -- a combination of challenges with no easy monetary fix. Making matters worse, these problems did not originate in India: they stem from the unintended consequences of U.S. monetary policy. Rajan now faces a policy dilemma with no easy answer.
After the housing bubble burst in 2008, the U.S. Federal Reserve slashed short-term interest rates to zero percent in order to stimulate bank lending and spur economic activity. The Fed also began a bond buying program known as quantitative easing, purchasing billions of dollars’ worth of long-term U.S. government bonds and mortgage-backed securities. From 2008 to 2014, the U.S. monetary base, which includes currency in circulation together with bank reserves, increased from $847 billion to roughly $4 trillion.
By boosting demand for U.S. bonds, quantitative easing lowered long-term interest rates in the United States. From October 2008 to the summer of 2012, the annual returns on ten-year U.S. Treasury bonds fell from four percent to 1.67 percent. Over the same period, 30-year U.S. Treasury bond yields fell from 4.35 percent to 2.56 percent. Adjusting for inflation, investors found themselves in the position of essentially paying the U.S. government to borrow their money. Low interest rates in the United States soon correlated with rising demand for assets in emerging markets. According to the Institute for International Finance, foreign holdings of government debt in Asian economies doubled from 2009 to 2013.
In a 2006 speech, Rajan, then the economic counselor and director of research at the International Monetary Fund, argued that lax monetary policy in rich countries could lead to dangerous macroeconomic distortions in developing countries. He claimed that investors purchase risky assets when advanced economies have falling interest rates, only to sell those assets when interest rates rise again. He termed this phenomenon “risk-shifting.”
To see why investors risk-shift, consider the case of a pension fund that promised a four percent annual return to its pensioners. The fund has to hold assets that match its promised obligations. When long-term interest rates fall from four percent to 2.5 percent, as they did under quantitative easing, the pension fund’s manager has to search elsewhere for higher yields, perhaps in a market like India, where assets still yield 4 percent. As more fund managers risk-shift, capital flows into risky markets, increasing asset prices, inflation, and trade deficits.
Now that the Federal Reserve is reducing, or “tapering,” its asset purchases by $10 billion per month, investors expect higher interest rates in the United States, causing risk-shifting to reverse: as interest rates normalize in the United States, fund managers will begin selling risky assets in emerging markets to buy safer assets at home. Investors will demand greater collateral, or higher interest rates, for their continued lending to emerging markets. As a result, firms and households in India may soon find it difficult to meet their maturing financial obligations. Vast sums of Indian wealth could be destroyed.